I am an attorney (www.lewissaret.com) practicing in the area of federal taxation, with particular emphasis on estate and business succession planning, based in the Washington DC metropolitan area. In addition, I am Chair and former Vice-Chair of the Fiduciary Income Tax Committee of the American Bar Association Section of Taxation. In the past, I have also served as Vice-Chair or Chair on a number of committees including the Asset Protection Planning Committee of the Real Property, Probate and Trust Section of the ABA. I am a prolific author and frequent speaker on tax and estate planning issues, co-authoring numerous books including Asset Protection Strategies: Tax and Legal Aspects and Valuation of Closely HeldBusinesses: Tax and Legal Aspects. I am also the co-founder of the Wealth Strategies Journal, an online journal pioneering to provide quality wealth management guidance available to the general public.

Portability Plans Vs Credit Shelter Plans Round 3: State Estate Taxes

Approximately 15 states have their own state estate taxes. Many of these states have exemption amounts that are less than the federal applicable exclusion amount. For example, the District of Columbia and Maryland have exemption amounts of $1 million, and New York has an exemption amount of $2,062,500. This means that estate plans for clients domiciled in such states or with real property located in such states will need to take state estate taxes into consideration. The portability election can impact this planning.

Most married couples prefer to not pay any estate tax at the death of the first spouse to die (“First Spouse”). As a result, most estate plans are designed to avoid the imposition of any estate tax at the First Spouse’s death. Since the traditional formula clause that funds a credit shelter trust to the maximum amount of the federal applicable exclusion amount would trigger state estate tax upon the death of the First Spouse, the estate plans that use such formula clauses are typically modified to avoid the state estate tax if the couple is domiciled in a state with state estate tax.

Under these circumstances, the following approaches tend to be the most widely used to modify the estate plans for married couples domiciled in states with state estate taxes:

This post will go into more detail about the disclaimer-based approach. Future posts will discuss the other approaches.

Disclaimer-Based Approach.

One approach used for married couples living in states with state estate taxes that are decoupled from the federal transfer tax system, especially for those with smaller estates, is a disclaimer-based approach. This approach relies on a qualified disclaimer to succeed. Therefore, a brief discussion of disclaimers is in order before describing how this approach works.

A disclaimer is a refusal or renunciation by an estate beneficiary or a donee of a gift of a transfer to the beneficiary during life or at death, by will, trust or otherwise. Federal tax law distinguishes between “qualified” and “nonqualified” disclaimers. If a disclaimer is a nonqualified disclaimer, the disclaimant is treated as having received the disclaimed property, interest or power from the original transferor and then having transferred that property right or interest, or released such power, to the person who takes it as a result of the disclaimer. Therefore, if the transfer is gratuitous, there may be estate, gift or GST tax consequences arising from the disclaimer. If the disclaimer is for consideration, income and capital gains tax consequences must be considered.

If a disclaimer is a qualified disclaimer, then for federal transfer tax purposes, the disclaimed property interest is treated as passing directly from the original transferor to the persons entitled to receive the property as a result of the disclaimer. Therefore, a qualified disclaimer causes the following results:

There is no gift being made by the disclaimant to the recipient of the disclaimed property interest for federal gift tax purposes.

For testamentary transfers, there is no transfer of the disclaimed property interest from the decedent to the disclaimant for federal estate tax purposes.

The GST tax will apply with respect to a property interest transferred under a qualified disclaimer as if the interest had never been transferred to the person making the disclaimer.

The disclaimer of a general power of appointment will not be treated as a lapse of that power under Code Sec. 2041.

The federal transfer taxes will be imposed as though the property interest had passed directly from the original transferor to the persons receiving the property interest as a consequence of the disclaimer.

To constitute as a “qualified” disclaimer, the disclaimer must be an irrevocable and unqualified refusal to accept an interest in property, which satisfies the following requirements:

The disclaimer is in writing.

The disclaimer is made and delivered within nine months of the creation of the interest.

There has been no acceptance of the interest or benefits.

As a result of the disclaimer, the interest passes to the surviving spouse or to a person other than the disclaimant without any direction on the part of the disclaimant.

Under a typical disclaimer-based approach, all of the First Spouse’s residuary estate passes to the surviving spouse. This part of the disclaimer-based approach is very similar to a so-called sweetheart will, which provides that the First Spouse’s estate passes outright to the surviving spouse. However, unlike a sweetheart will, in a disclaimer-based approach, the First Spouse’s estate plan provides that if the surviving spouse disclaims his/her interest, it then passes to a backup disclaimer credit shelter trust.

The benefit of this approach is that it builds in flexibility, which allows the surviving spouse to make decisions taking into account changes in legal and financial circumstances after the documents are executed and the First Spouse has passed away.

The disadvantages of this approach include the following. First, in order to constitute a qualified disclaimer, there must be no acceptance of the interest or benefits from the interest. Second, the surviving spouse must proactively execute a disclaimer within nine months of the date of death. Because it is very easy to fail one or both of these requirements, the disclaimer approach is less than ideal.

Example 1. Jed and Jane are married and have two children, Jethro and Ellie. Jane owns JJ Farm. Jane dies on January 1, 2013, and leaves JJ Farm to Jed via a will that includes a backup disclaimer credit shelter trust. Jed pledges JJ Farm as security for a short-term loan on March 1, 2013, which he repays on May 1, 2013. On June 1, 2013, Jed disclaims his interest in JJ Farm.

Here, Jed’s disclaimer is not a qualified disclaimer because he has “accepted” JJ Farm for tax purposes, thus disqualifying the disclaimer. As a result, the farm is treated as passing from Jane to Jed, and then from Jed to the backup disclaimer credit shelter trust.

Example 2. Same facts as Example 1 except that (1) Jed does not pledge JJ Farm for a loan, and (2) Jed does not disclaim his interest in JJ Farm until December 1, 2013. Here, although the disclaimer may be valid under applicable state law, because Jed did not make the disclaimer within nine months of Jane’s death, it is not a “qualified” disclaimer for federal transfer tax purposes. As a result, the farm is treated as passing from Jane to Jed, and then from Jed to the backup disclaimer credit shelter trust.

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